Which of the following are the assumptions of Modigliani and Miller’s Dividend Irrelavance Theory ? A. Perfect Capital Market B. No taxes C. No transaction Cost and no time lag D. Fixed Investment Policy E. Investors behave irrationally Choose the correct answer from the options given below :
A, B, C and D only
A, B, C and D are the assumptions; E is not — option 3.
The assumptions of the Modigliani-Miller dividend irrelevance hypothesis (1961).
| Assumption | Why the argument needs it |
|---|---|
| A. Perfect capital market | Information is free and available to all; no investor is large enough to move prices; securities are infinitely divisible |
| B. No taxes, or no difference between the tax on dividends and on capital gains | If dividends were taxed more heavily than capital gains, investors would prefer retention and the policy would matter |
| C. No transaction costs and no time lag | An investor who wants cash can sell shares costlessly and instantly — creating his own “home-made dividend” |
| D. Fixed investment policy | The firm’s capital budget is decided independently of its dividend, so paying a dividend never causes a profitable project to be abandoned |
| E. Investors behave irrationally | Not an assumption — the model assumes exactly the opposite. The whole argument rests on rational investors who are indifferent between a rupee of dividend and a rupee of capital gain, and who arbitrage away any difference |
Recognising that E states the reverse of a standard assumption is enough to answer the question: every option containing E is wrong, which leaves only option 3.
The argument itself. Under these conditions the value of a firm is determined by its earning power and the risk of its assets — that is, by its investment policy — and not by how it divides earnings between dividend and retention. A shareholder who wants income can manufacture it by selling shares; one who does not want income can reinvest the dividend. Since the investor can undo whatever the firm does, at no cost, the firm’s choice cannot affect his wealth.
Why the conclusion is disputed in practice. Every assumption fails to some degree — taxes differ between dividends and gains, selling shares costs money, and information is not free. Two counter-arguments follow :
| Argument | Content |
|---|---|
| Bird-in-the-hand (Gordon, Walter) | Investors prefer a certain dividend now to an uncertain gain later, and discount retained earnings more heavily |
| Signalling | Because managers know more than investors, a dividend increase is read as a signal of confidence — so the announcement itself moves the price |
Hence, the answer is A, B, C and D only.
Similar Questions
A public works project is proposed that has total present-worth benefits of ₹ 75 million and total present-worth cost of ₹ 55 million. In deliberating this proposal, some members of the Municipal Board have suggested that the project has a total present-worth disbenefits of ₹ 15 million; other members feel that ₹ 15 million should be treated as a cost. What will be the benefit cost ratio and net benefits value while considering the disbenefits as a cost?
Select the correct statement/s from the following :
Statement I : The slope of the NPV profile reflects how sensitive the project is to discount rate changes.
Statement II : To find total NPV of more than one projects, their NPV cannot be added.
Statement III : The certainty equivalent coefficient applies adjustments to both, the cash flows (in the numerator) and the discount factor (in the denominator).
Statement IV : The risk - adjusted discount factor applies adjustment for risk only to the discount factor (denominator).
Codes :
Indicate the correct code of the combinations of the following methods commonly used for capital budgeting:
a. Payback Period
b. Profitability Index
c. Utility theory
d. Internal rate of return
Codes:
NPV and IRR methods of investment evaluation may give divergent accept-reject decisions on account of which of the following?
a. Varying initial investment
b. Divergent cash flows from the investment projects
c. Disparity in the lives of the investment projects
Indicate the correct code of their combinations.
Codes:
Under the Modified Accelerated Cost Recovery System (MACRS) an asset in the “5 year property class” would typically be depreciated over how many years ?
Select the correct statement/s from the following:
Statement I: The slope of the NPV profile reflects how sensitive the project is to discount rate changes.
Statement II: To find total NPV of more than one projects, their NPV cannot be added.
Statement III: The certainty equivalent coefficient applies adjustments to both, the cash flows (in the numerator) and the discount factor (in the denominator).
Statement IV: The risk-adjusted discount factor applies adjustment for risk only to the discount factor (denominator).
Codes:
Statement – I : In general, the NPV and IRR methods lead to the same acceptance or rejection decision when a single project is involved.
Statement – II : The inconsistency in ranking of competing projects as per the NPV and IRR methods lies in the implicit assumptions with regard to different rates of returns on re-investment of intermediate cash flows.
Code :
The capital budgeting appraisal criterion that is most appropriate in the situation of capital rationing will be:
For computation of cost of equity, arrange the following measures in the ascending order of accuracy:
I. Capital Asset Pricing Model
II. Dividend-Price Ratio
III. Earning-Price Ratio
IV. Dividend-Price Plus Growth Ratio
Match the correct options for the following capital budgeting appraisal criteria:
List - I List - II a. The criterion based on the cash flows of a limited period. i. Internal Rate of Return b. The criterion based on profit over life of the project. ii. Pay-back Method c. The criterion that considers cash flows over the life of project which considered the time value of money. iii. Accounting Rate of Return d. The criterion that derives the outcomes in terms of the rate of return considering the cash flows over the life of project with the time value of money. iv. Net Present Value
Important Questions from Capital Budgeting
A firm is currently earning Rs. 50,000 and its one share has a present market value of Rs. 175. It has 5,000 shares outstanding. The earnings of the firm is expected to remain stable and it has a payout ratio of 100%. The cost of equity is:
With project cost of ₹300 lacs, profits after depreciation (straight line method) and tax for its lifetime of 5 years are estimated at ₹10 lacs, ₹10 lacs, ₹30 lacs, ₹40 lacs and ₹50 lacs respectively. The cost of capital is 12% and discount factors @ 12%, for the first five years are 0.89, 0.80, 0.71, 0.64 and 0.57 respectively. The Net present value of project is :
Match List I with List II
LIST I
(Investment Decision rule)
LIST II
(Feature)
A. NPV I. Insufficiently consistent B. Payback II. Highly Inflexible C. Cash Returns III. Balance between flexibility and consistency D. Accounting Returns IV. Relatively consistent Choose the correct answer from the options given below:
If the Net Present Value (NPV) of an investment proposal is positive, what conclusions can be drawn?
A. The investment generated present value of cashflows exceed cost of investment
B. The discount rate used is less than the investments estimated return
C. The discount rate used equals the minimum return required by the investors
D. The investment generated present value of cashflows equals the cost of investment
E. The investment's Internal Rate of Return (IRR) exceeds the Cost of Capital
Choose the correct answer from the options given below:
Arrange (in descending order) the following present value of a growing perpetuity which makes first payment of Rs. 3,000 in next year.
A. Present value at 8% growth and 10% discount rate.
B. Present value at 3% growth and 9% discount rate.
C. Present value at 6% growth and 11% discount rate.
D. Present value at 5% growth and 6% discount rate.
E. Present value at 1% growth and 4% discount rate.
Choose the correct answer from the options given below
